Five investment strategies to deal with volatile markets

After a period of relative calm, share markets saw return to volatility recently. This article looks at the main drivers and how long this period of weakness may last.

The weakness in sharemarkets reflects a range of factors:

After gains of 15 to 20 per cent since February lows (and a brief interruption around the Brexit vote), shares had become vulnerable to a pullback. Adding to this vulnerability was very low volatility in the US sharemarket, which can be seen as a sign of short-term complacency on the part of investors.

This is particularly so as we are now in a seasonally weak part of the year. August to October is notorious for sharemarket weakness, which can be seen in the chart below showing the seasonal pattern in markets since 1985 (after removing the underlying rising trend). Shares tend to rise from November to around May and then have weakness around the September quarter.

Source: Bloomberg, AMP Capital

There has been a back-up (rise) in bond yields globally, which puts pressure on both the comparative attractiveness of shares and, directly, on parts of the sharemarket (like utility companies) that pay high dividends and are seen as an alternative to bonds. The rise in bond yields is due to a range of factors. These include perceptions that central banks (notably the Bank of Japan and the European Central Bank) may be reaching the limits of what they can do; talk of a refocus from monetary stimulus to fiscal stimulus; receding deflationary pressure as commodity prices stabilise; perhaps the realisation that bonds are poor value; and fears of renewed US Federal Reserve rate rises at a time when US economic data has been a bit mixed.

There are a range of events looming over the next few months that may be causing investor nervousness: uncertainty about the Fed as already mentioned; the potential for new worries about a Eurozone break-up with a presidential election re-run in Austria in early October (involving a far right Eurosceptic candidate) and a November referendum to reform the Italian Senate; the US election in November; and South China Sea tensions and North Korean bomb tests.

In Australia, a perception that we are at or close to the end of the Reserve Bank’s monetary policy easing cycle has added to upward pressure on local bond yields, which has affected local shares.

Just another correction or a renewed bear market?

Given the nature of sharemarkets, the weakness could have a way to go. Once falls get underway they add to fear, which creates more selling and the seasonal and risk factors mentioned above arguably have further to run.

A correction likelier than bear market

However, there are several reasons why this is probably a 5 to 10 per cent correction as distinct from a resumption of the bear market that began in the June quarter last year and took many sharemarkets – including Australian shares – down 20 per cent or more to their lows in February this year.

First, bond yields are unlikely to rise too far. The giant long-term bond rally that got underway in the early 1980s is probably in the process of bottoming out, as central banks get close to the end of monetary easing, fiscal austerity gives way to fiscal stimulus and a stabilisation in commodity prices leads to a lessening of deflation risk.

But so far the back-up in bond yields, while it might feel big, is just a flick off the bottom, looking like just another correction in the long-term bond bull market. It is hard to see a sharp back-up in bond yields as global growth remains subdued and fragile, core inflation remains well below inflation targets, US Federal Reserve rate rises are likely to remain gradual, the European Central Bank and Bank of Japan are a long way from ending stimulus or starting rate rises, and any shift to fiscal stimulus is likely to be gradual and modest.

The Fed is probably edging towards another rate rise and recent mixed data makes a December move more likely. Bond yields are more likely to trace out a bottoming process like we saw in the 1940s and 1950s, rather than a sudden and sustained lurch higher.

Source: Global Financial Data, Bloomberg, AMP Capital

Second, sharemarket valuations are not onerous for a low-rate world – assuming we are right and it remains that way. While price-to-earnings multiples for some markets are a bit above long-term averages, valuation measures that allow for low interest rates and bond yields show shares to be cheap.

Source: Thomson Reuters, AMP Capital

Third, the global economy is continuing to muddle along and Australian growth is solid. US economic growth appears to have picked up after another soft spot early this year; Chinese economic growth has stabilised just above 6.5 per cent; global business conditions surveys (or PMIs as they are called these days) are at levels consistent with continued global growth around 3 per cent and are nowhere near signalling anything approaching recession (see the chart below).

Australia is continuing to grow. Consumer spending, housing construction, a resurgence in services like tourism and higher education exports, and booming resource export volumes (the third phase of the mining boom) are keeping the economy going at a time when the drags on growth from the end of the commodity prices and mining investment booms are close to fading.

Source: Bloomberg, AMP Capital

Low likelihood of recession

The low likelihood of a recession is very important. Ignoring the 20 per cent fall between April 2015 and February this year, since 1900 there have been 17 bear markets in Australian shares (defined as falls of 20 per cent or more). Eleven bear markets saw shares higher a year after the initial 20 per cent decline. The remaining six pushed further into bear territory with average falls over the next 12 months, after having declined by 20 per cent, of an additional 22.5 per cent.

Credit Suisse, focusing on the period from the 1970s, called these Gummy bears and Grizzly bears respectively.

Source: ASX, Global Financial Data, Bloomberg, AMP Capital

The big difference between them is whether there is recession in Australia or the US, or not. Grizzly bears tend to be associated with recessions but Gummy bears tend not to be. So if recession is avoided, as I think it will be, the bear market that ran from April 2015 to February this year in Australian shares is unlikely to resume and markets are more likely to remain in a rising trend.

Finally, if recession is avoided the profit outlook should continue to improve. There are some pointers to this: US earnings rose 9 per cent in the June quarter and are likely to have bottomed as the negative impact of the fall in oil prices and the rise in the US dollar has abated; and Australian profits should return to growth this financial year as the impact of last year’s plunge in commodity prices – which drove resource profits down 47 per cent – falls out.

Five things investors should consider doing

After a strong rebound in sharemarkets from the February lows, we seem to have entered a rougher patch. However, with most sharemarkets offering reasonable value, global monetary conditions remaining easy and no sign of recession, the trend in shares is likely to remain up.

But times like the present can be stressful, as no one likes to see the value of their investments decline. The key for investors is to:

Recognise that we have seen it all before as periodic sharp falls are regular occurrences in sharemarkets. Shares literally climb a wall of worry with numerous events dragging them down periodically, but with the trend ultimately rising and providing higher returns than more stable assets.

Avoid selling after falls as it just locks in a loss.

Allow that when shares and all assets fall in value they are cheaper and offer higher long-term return prospects. So the key is to look for investment opportunities that pullbacks provide. It is impossible to time the bottom but one way to do it is to average over time.

Recognise that while shares may fall in value, the dividends (or income flow) from a well-diversified portfolio of shares tends to remain relatively stable and continues to remain attractive, particularly against bank deposits. Australian shares are offering an average, grossed-up for franking credits, dividend yield of around 6 per cent compared to term deposit yields of around 2 to 3 per cent.

Turn down the noise. At times like the present the flow of negative news reaches fever pitch, making it harder to stick to an appropriate long-term strategy, let alone see the opportunities that are thrown up.

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This article appeared in the October 2016 ASX Investor Update
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This article appeared in the October 2016 ASX Investor Update email newsletter. To subscribe to this newsletter please register with MyASX.

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